Efraim Benmelech on Financial Contagion

The economist explains how financial crises spread like a disease and what companies can do to immunize themselves.

When the global economic crisis took hold in 2008, a central concern among economists and officials was contagion: the idea that the failure of one company (or one sector of the economy) would spread to others like an infectious disease. This type of risk is familiar to people who study financial events, but until recently little light had been shed on how to most effectively recognize and, thus, address it.

Such was the purpose behind groundbreaking research by Efraim Benmelech, an associate professor of finance at the Kellogg School of Management. Together with Nittai Bergman of the MIT Sloan School of Management, Benmelech has demonstrated that an effective response to a financial crisis begins by understanding its roots: Was it caused by a systemic shock that simultaneously hit everyone in the sector (be that defined by industry or geography), or did it originate with a single, company-specific malady—a contaminant?

Efraim Benmelech on Financial Disease

The associate professor of finance at the Kellogg School of Management discusses the life cycle of a financial crisis.

Focusing on the airline industry, Benmelech and Bergman devised a method for pinpointing the origins of major financial events and, thus, giving direction to the most effective remedy. Their work also informs how companies can shield themselves from the worst effects of a financial outbreak. Their research won the Journal of Finance’s annual Brattle Prize, given for the best paper in finance, in 2011.

Before his academic career, Benmelech served briefly as a junior economist at the Israeli Ministry of Finance, which sparked his interest in debt and credit markets. Since completing a Ph.D. at the University of Chicago’s Booth School of Business in 2005, he has studied bankruptcy, corporate finance, and financial distress, among other things. He has won numerous awards, including the 2004 Lehman Brothers Fellowship for Research Excellence in Finance and the Review of Corporate Finance Studies Best Paper award in 2012.

He talked to s+b about the genesis of financial contagion and how companies can best protect themselves.

S+B: What did your research add to what is already known about the risk of financial contagion?
BENMELECH: We were able to make a case for a causal effect.

Let me begin by talking about contagion and the empirical challenges that are involved in understanding it. Contagion begins with an entity facing some form of financial difficulty, even a bankruptcy. The effects are not isolated to the firm, but spread out and cause financial distress among other companies that are associated with it—they could be suppliers, customers, bankers. They are often competitors.

But not all financial disruptions are driven by contagion, and once a crisis has happened, the cause is not immediately obvious. This is the main difficulty we have whenever we deal with the empirical evaluation of contagion: How can we tell whether this is real contagion in which one country or one firm is causing the distress or it is just a reflection of a bad situation, a bad jolt that has affected everyone?

There is a huge difference between the two. Where there is contagion, we can—potentially—help one sick firm, and, by doing that, help heal other firms. In the second case, a broader remedy is required—for instance, a major policy intervention.

Let me be more specific about contagion by drawing on our research of the airline industry. Let’s say for the sake of argument that Airline One is flying only Boeing aircraft. Airline Two flies two types of aircraft, Boeing and Airbus. Airline Two has issued two bonds. One is secured by Boeing, and the other is secured by Airbus.

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